David Ricardo, in his Principles of Political Economy (1817), furnished a more precise formulation of the theory of international trade. At the centre of the Ricardian theory of international trade is the celebrated principle of comparative advantage of “doctrine of comparative costs.”
In fact, the doctrine of comparative costs was developed by Ricardo out of his (classical) labour theory of value. According to this theory, the value of any commodity is determined by its labour costs.
It asserts that, goods are exchanged against one another according to the relative amounts of labour embodied in them. For the prices of goods within a country are proportional to the relative quantities of labour contained by them. Thus, the exchange ratios or prices are determined solely by relative labour costs, through their influence upon supply and demand.
If the goods of a particular industry have their prices higher than their labour costs, additional labour moves to this industry from other occupations. Hence, the supply of that industry’s goods will expand until their prices equal their labour costs. The labour cost principle, therefore, implies that there is a tendency of wages toward equality within a country, so that, prices of goods will be equal to their labour which may equalise the return to labour in all productions and regions throughout the country.
The labour cost principle is, however, based on the following assumptions that:
1. Labour is the only productive factor,
2. All labour is of the same quality and characteristics,
3. Labour has perfect mobility,
4. There is perfect competition in the labour market.
Ricardo, thus, thought that the labour theory of value, which is completely valid for the domestic trade of a country, cannot be applied to international trade, since factors of production are immobile internationally.
Like other classical economists, he also believed that, labour is completely mobile within a country and therefore, distributes itself among the different branches of production in such a way that its marginal productivity is everywhere equal to its wages.
This rule does not apply to international trade, since labour is not mobile between countries. In short, the labour cost principle does not govern value in exchange transactions in international trade. The question, therefore, arises: what determines values in international exchange?
To explain this, Ricardo developed his Doctrine of Comparative Costs. In developing the theory of comparative costs, Ricardo sought to explain why different countries specialised in the production of different commodities, or what is the basis of international trade.
According to the theory of comparative costs, international trade takes place because different countries have different advantages (efficiency) in the production (specialisation) of different commodities.
A country will specialise in the production of that commodity in which it has a greater comparative advantage or its comparative disadvantage is the least. It follows thus that the country would export the commodity in which it has comparative advantage, and import the commodity in which its advantage is less or in which it has a comparative disadvantage.
Assuming a simple two-country, two-commodity, one-factor (labour) model, Ricardo seeks to elucidate the above-stated theory in terms of the labour cost principle by means of his celebrated arithmetical example as follows:
Suppose, in Portugal a unit of wine costs 80 hours and a unit of cloth 90 hours of labour; in England a unit of wine costs 120 hours and a unit of cloth 100 hours of labour. Now, if we compare the cost of production in both the countries, for international trade to take place, the position will be as shown in.
We observe that costs of producing both commodities (wine and cloth) are lower in Portugal As compared to England, she has an absolute advantage in producing both the goods. For, 1 unit of wine costs her 80 hours of labour, whereas, it costs 120 hours in England to produce the same amount.
Similarly, in producing cloth also it costs her 90 hours of labour for 1 unit while England has to use 100 hours of labour to produce the same amount. However, Portugal has a comparative advantage over England in the production of wine relatively to cloth. For, comparatively her labour cost involved in producing 1 unit of wine is only 80/ 120×100 = 67 per cent of England’s labour cost involved in wine, while in producing cloth she has to involve 90/100 x1OO = 90 per cent of English labour cost to produce 1 unit of cloth. That means, Portugal is comparatively more efficient in wine-making than in cloth-weaving.
It should be noted that to know the comparative advantage, we have to compare the ratio of the costs of production of one commodity in both countries (i.e., in the case of wine in our example) with the ratio of the cost of producing the other commodity in both countries (i.e., in the case of cloth in our example).
Follows thus, that the disadvantage of England is greater in wine than in cloth. England, in fact, has an absolute disadvantage in producing both the goods (wine and cloth). It has, however, lesser disadvantage in producing cloth than wine in comparison to Portugal, for in wine production it involves 33% more of Portuguese labour cost and in cloth it is only 10% more. Evidently, Portugal has a comparative disadvantage of costs in producing cloth.
It should be remembered, therefore, that a comparative cost advantage is always and by definition accompanied by a comparative disadvantage of cost too. That is to say, when Portugal has a comparative cost advantage in wine, she has a comparative disadvantage in cloth (irrespective of her absolute advantage in both). Under these circumstances, Ricardo argued, it would be advantageous for both the countries to have trade relations and Portugal should export wine and import cloth, while England should export cloth and import wine.
The advantage or gain from international trade to both is seen in this table of labour cost structure comparison; since in England labour cost of wine (120 hours) is greater than that of cloth (100 hours), more cloth can be purchased in exchange for wine. Thus, domestic terms of trade in England will be 1 unit of wine being exchanged for 1.2 units of cloth.
In Portugal, the labour cost of wine (80 hours) is less than that of cloth (90 hours), hence, less cloth can be purchased in exchange for wine. Thus, domestic terms of trade in Portugal will be 1 unit of wine being exchanged for 0.89 units of cloth.
It is, therefore, advantageous to Portugal to export wine to England, where 1 unit of wine commands 1.2 units of cloth. (Thus, she gets more than 0.89 unit of cloth against 1 unit of wine). Similarly, it is relatively advantageous for England to export cloth to Portugal, where 0.89 unit of cloth against 1 unit of wine (so that, she has to give less than 1.2 units of cloth in exchange for 1 unit of wine).
Therefore, Portugal should export wine and import cloth while England should export cloth and import wine. In any exchange ratio between the two countries (international terms of trade) between 0.89 and 1.2 units of cloth against 1 unit of wine represents a gain to both countries. If we assume international terms of trade as 1 unit of wine = 1 unit of cloth, then, in case of England in terms of real cost, for exporting 1 unit of cloth embodying 100 labour hours, she received (import) 1 unit of wine which would have cost 120 labour hours, produced internally. Obviously, then she saves 20 hours of labour through international trade. Likewise, Portugal obtains cloth at a cost of 80 hours of labour per unit which otherwise (if produced internally) would have cost 90 hours of labour. Thus, she saves 10 hours of labour through international trade.
Comparative Costs Doctrine:
Specialises in wine and England in cloth, and if trade occurs between them at 1 W = 1 C terms of trade as represented by TA line, then both countries gain. England gets 0.17 units (or ET) more of wine than before trade. Similarly, Portugal gets 0.11 units (or P’A) more of cloth than before.
To state in algebraic terms:
If, in country I, the labour cost of commodity A is at and that of B is b,; and in country II it is a2 and b2 respectively, then absolute differences in cost can be expressed as:
(Which means that country I has an absolute advantage over country II in A and country II has over I in B). And, comparative differences in costs are expressed as:
(Which implies that country I possesses absolute advantage over country II in both A and B; but it has comparative
Advantage ill A than in B). If, however, there is equal cost difference, i.e.
International trade between the two countries.